ECB signals it is on the road to normal

First of all, whereas before the ECB signaled the need for tight policy going forward (committing to ‘keep policy rates sufficiently restrictive for as long as necessary’), it now signals that ‘it will follow a data-dependent and meeting-by-meeting approach to determining the appropriate monetary policy stance.’

Second, the ECB’s economists now expect inflation to return to the target earlier. Indeed, inflation has generally been revised down in the updated projections, partly reflecting a weaker economic outlook (see charts below). More generally, the central bank’s confidence in the inflation outlook continues to build. One aspect emphasised by President Christine Lagarde is that this was the sixth forecast round in a row in which the central bank was projecting inflation at 2% in 2025, showing that the period of upside surprises had passed.

Indeed, the Council judged that the risks to inflation were now more balanced (‘two-sided’) around this projection. Risks to the economic outlook were to the downside, which also meant that inflation could turn out lower. However, on the other side, higher domestic inflationary pressures, geopolitics and climate events could see inflation turn out higher than forecast.

Ms Lagarde also asserted that the monetary policy stance was restrictive and that the direction of travel currently was very clear. The level of the neutral rate was not debated, but would be ‘when we get there’. While stressing the uncertainty around neutral, she did note that ECB’s economists suggested a range of 1.75-2.5% based on their analysis.

In terms of what happens beyond neutral, this will likely rest on how the outlook develops. The ECB President noted that the policies of the new US administration were largely not included in the baseline projection, with the exception of the extension of the tax cuts. She said that the ultimate (medium term) impact of tariffs on inflation was uncertain and would depend on their scope, whether there was retaliation from other countries and the extent to which trade was re-routed. However, for the short-term horizon (which we think is less relevant for monetary policy decisions) tariffs would on balance be inflationary.

We expect the ECB to continue to cut rates by 25bp at each Governing Council meeting this year and into next, with the exception of a pause in April. Eventually, we see the ECB taking its deposit rate all the way down to 1%. This reflects two considerations, where we differ from the ECB’s analysis. First of all, we judge that the neutral interest rate in the eurozone is lower, given that demographics and weak productivity are weighing on trend economic growth. We see the neutral rate at around 1.5%.

Second, we think that tariffs will ultimately prove to be a disinflationary shock. We think EU retaliation to US tariffs will be targeted, limiting the direct impact on inflation. Inflation will be weighed down by the negative impact on growth domestically, but also by weakness in global trade and manufacturing, which would dampen industrial goods and commodity prices. This should see inflation undershooting the target over the medium term, which would require an accommodative monetary policy stance.